Wednesday, January 6, 2016

China: Even After Today's Action the Yuan Is Still Overvalued

...Stocks
plunged, for the second times this week, after the renminbi saw its
biggest one-day weakening since China’s surprise devaluation last
August. Currency concerns have spooked China’s markets which have gone
into a replay of last summer’s meltdown and left policymakers struggling to contain the fallout.

On
Wednesday, the People’s Bank of China fixed the midpoint — the level
around which it permits the onshore currency to trade 2 per cent — at
Rmb6.5646, 0.51 per cent weaker than Wednesday and its biggest one-day
weakening since China’s surprise devaluation in August first alerted
investors to renminbi risk....

Another Yuan Devaluation Coming Up?
Currency trends suggest another yuan devaluation is coming up. Specifically,
the gap between the mainland China yuan (renminbi) to the US dollar, vs. the
offshore floating rate of the yuan to the US dollar is now at a record high.

The reason there are two rates is China has tight controls on the range the
yuan trades in China, but the yuan floats outside China.

In contrast to previous years where traders bet the value of the yuan would
rise vs. the US dollar, traders are increasingly betting China will devalue.

Explaining Chinese Capital Flight
If China had no capital controls, the onshore and offshore rates would have
to be identical otherwise there would be an instant guaranteed free money arbitrage
opportunity in virtually unlimited size were China to maintain a peg the market
did not agree with.

Here are a couple of charts that show what I mean....

...Onshore / Offshore Rate Differentials

The onshore rate is 6.5567 per US dollar.

The offshore rate is 6.6993 per US dollar.

Another 2% Devaluation?
The onshore yuan is weaker than offshore by 0.1426. That a bit over 2%.

In the absence of capital controls one could make an instantaneous 2% on an
unlimited amount of money. That such spreads exist shows that capital controls
work, for the most part, at least for now.

However, capital controls are not perfect. Those able to skirt capital controls
do so. One possible method of free arbitrage would be export/import trades
that do not really take place, or simply padded higher.

Fraud of such nature cannot be unlimited. $1 trillion in sudden exports or
imports is going to get caught, but smaller amounts can be hidden.

In addition, those sitting with a lot of money in a depreciating currency
don't exactly like that outcome. Thus capital flight pressure is intense for
two reasons.

One way or another (slowly over time, or by another 2% devaluation), the yuan
appears destined to sink. When will it stop?...MORE